Yellen’s not so symmetrical inflation target

Yesterday the Federal Reserve raised its key policy rate by another 25 basis points. This surprised no one and was nearly fully priced in by the market.

More startling were Fed Chair Janet Yellen’s comments at the post-meeting press conference, where she insisted on downplaying any downside risk to inflation. She did so despite price data that have consistently surprised on the downside in recent months and inflation expectations – from both markets and surveys – that have dropped significantly since the previous rate hike in March. To make matters worse, the Fed announced a fairly aggressive plan for balance sheet ‘normalization’.

It is hard to avoid the conclusion that Janet Yellen puts no real emphasis on monetary analysis. Instead, she seems to be relying on 1970s-style Phillips curve analysis – ‘since unemployment is low, inflation will have to rise soon’. Our view is that this seriously damages the credibility of the Fed’s 2% inflation target.

During yesterda’s press conference, Ms. Yellen argued that the Fed’s 2% inflation target is ‘symmetrical’. That claim is hard to believe, as the graph below illustrates.

It shows changes in the PCE core price level, which the Fed has officially targeted at 2% since 2012.

The yellow line shows how the price level should have developed had the Fed hit its target. But as one can see, that didn’t happen. Instead, policymakers have consistently missed the target on the low side.

Janet Yellen’s term as Fed chair began in February 2012. If we start from that date, we see that she has been even worse at undershooting the 2% inflation target than Ben Bernanke.

Not that Mr. Bernanke was much better. If we start in January 2007, when he took over from Alan Greenspan, we see that the Fed has fallen below the 2% price level for nine (!) years.

So it is hardly surprising that investors aren’t buying Janet Yellen’s assurance that the 2% inflation target is symmetrical. They draw a different conclusion. They think the Fed has further reduced its inflation target.

And this is only the first market reaction. We are genuinely worried about what comes next.